Capitalism 101

Physicians' new clout with investors

On a recent Saturday afternoon, the 60 internists and family practitioners from Health First Physicians in the Denver area gathered for a strategic planning retreat. One of the top items on the agenda for the five-year-old group practice was where to find cash to help it keep expanding.

Many of the physicians were surprised by what they heard. As the group's chief executive officer (CEO) Ruth Benton explained, there are quite a few Daddy Warbucks out there interested in backing physician groups. Wall Street, venture capitalists and even local banks are ready and willing to invest in doctors. No longer is selling out to a hospital or health system the only option for physician groups that need money—although it may be the best option for some.

"The biggest message I have for physicians is that money is out there," Ms. Benton said. "If group practices get their act together and have a good strategic business plan, they can find plenty of equity capital."

For group practices, that's good news. As physicians cope with ever-tightening reimbursements and position themselves to accept capitated payment, many are finding that they need an infusion of cash now more than ever.

According to the Medical Group Management Association (MGMA), the capital requirements to create the sophisticated kind of physician organization necessary to compete in today's medical marketplace begin at several hundred thousand dollars and can easily top millions. This includes the cost of acquiring physician practices, building or renovating facilities, upgrading information systems and paying for top-notch management. (See "The top 10 reasons groups need capital".)

The new mindset

It has only been in the '90s that physicians have felt the need to think like business executives. Before managed care, most physicians in most communities could make a good living and put aside money to upgrade their practices simply by seeing patients. Good cash flow meant they didn't have to put aside savings, they didn't have to invest in their practices and they rarely had to borrow for their businesses.

The result is that many physician practices have little to no equity. "Doctors take everything that is not nailed down as compensation," said Hobart Collins, a Louisville, Ky.-based consultant with MGMA. "They don't retain earnings. They don't have reserves. They don't typically save for a rainy day."

Consider, for example, the 150 primary care doctors in central Connecticut who came together last June as a new group called ProHealth Physicians. Most of these physicians had already been approached by hospitals and national for-profit physician practice management (PPM) companies like PhyCorp and MedPartners seeking to buy them. Instead of taking money from either, however, the physicians each put up $3,000 to $6,000 and merged into a group that would have the negotiating clout to win global capitation contracts, said David Brown, MD, a pediatrician and the group's president and CEO.

Eventually, however, the fledgling group ran out of money. At that point, the doctors approached a venture capitalist, who gave the group a loan that can later be converted to stock worth up to 30% of the company. That infusion of cash gave the practice enough money to continue the merger process.

The investor makes his return if the group sells the company at a profit or goes public. The latter, Dr. Brown said, is a distinct possibility, because the group will need more money to continue to recruit more doctors and expand its geographical reach by opening several state-of-the-art medical buildings.

Interestingly, Dr. Brown explained that the investor in his practice is not a board member. "Even if we go public, we're going to maintain enough stock in the hands of doctors that we will control the company," he said. That's because unlike most hospitals, a growing number of investment bankers and venture capitalists seem willing to finance group practices without insisting on owning a majority share of the group—or even on having a seat on the board.

Dr. Brown explained that with his group, the fact that the physicians have retained control could be a big selling point for investors. "According to our investor, the market will want to see that," he said. "If potential investors believe the doctors truly control the company, it will be successful."

Alternatives to selling

This is not to say that the only way to access enough money to be successful in today's marketplace is by giving up your small practice to become part of a large group. David Palmquist, ACP Member, an internist in a four-doctor private practice in Denver, has found capital to cover shortfalls and insulate the doctors against risk by looking at his practice's capitation contracts. He realized that much of the money from those contracts goes to the hospital instead of the primary care physicians. By restructuring those contracts through a doctor-oriented IPA, he has been able to get more cash to help his practice grow.

Previously, the PHO his group had worked with seemed to always negotiate contracts that favored the hospital over primary care physicians. The experience led Dr. Palmquist to believe that doctors "can't let anybody else do the contracting for them," without risking payment schedules that would work to the physicians' disadvantage.

"I think the key is to align with an effective IPA," Dr. Palmquist said. "We live or die by the contracts our IPA is able to arrange with the insurance companies."

Why not join a larger group that offers the same—or better—negotiating clout as an IPA? Dr. Palmquist said that he tried joining a large group practice, but that group dynamics, personalities and timing eventually destroyed the arrangement.

Investors have recognized that physicians often have difficulty forming groups that really work. Robert Daly, managing director of the Weston, Mass.-based firm Medical Equity LLC, likes a type of physician integration model he is calling a "superglue IPA." In the model, an IPA gets investor financing to purchase "true contracting exclusivity" from each doctor so that it then can impose real medical management on the doctors. (Since they are not a true group, the doctors can run the fee-for-service aspect of their businesses however they wish.) The IPA has to include at least 50 primary care physicians to attract investors, explained Mr. Daly, who is currently starting a "superglue IPA" in New York City.

"My message is that you can stay independent," Mr. Daly said. "You don't have to sell to the hospital. You don't have to sell to the national PPM. But you do have to do something. And the way you can stay independent, physician-owned and physician-managed is to get some mass and some scale. You can either do that within a group, or you can do that with one of these 'superglue' deals."

Planning ahead

What about the horror stories from physicians who made bad decisions to sell to a partner they cannot work with? Experts say that such situations are usually the result of doctors being blinded by the often substantial amounts of cash being dangled before them.

"They focused on the money, but not on the overall strategy and also on what value each party brought to the other," said Richard L. Clarke, president of the Healthcare Financial Management Association in Westchester, Ill., and co-author of a new book, "Capitalizing Medical Groups: Positioning Physicians for the Future."

That's why some health care consultants contacted for this article said physicians must decide how much risk they're willing to accept—and their long-term goals—before linking up with an investor.

Mr. Clarke emphasized that good capital partners provide more than simply cash. They also add value to the group in terms of better management or efficiency or effective contracting.

Therefore, it is only after deciding that the group needs capital to increase—or even maintain—market share that the doctors should think about where they might locate this financing. Dean C. Coddington, a Denver-based consultant and co-author of the "Capitalizing Medical Groups" book, reflecting the advice of many consultants, laid out many of the top options for finding the cash:

Saving. "Even internal medicine physicians, who are not the most highly paid, need to seriously consider retaining some earnings or setting aside reserves," Mr. Coddington said. Although there is no hard and fast rule, consultants put the set-aside figure at about 5% to 10% of earnings.

Ms. Benton of Colorado's Health First Physicians said her 60 physicians save by putting part of the monthly fee they pay for management into a savings account. By building up a nest egg, she said, the practice is able "to show our equity partners and our bankers that we're a viable company." The practice also has money on hand to pay bonuses to the physicians.

Mr. Coddington pointed out, however, that putting aside some of a practice's earnings means that many physicians will need to view their practice in a new light. "It requires stepping back and not thinking of the group as merely a place to go to work and practice," he said, "but as a business that has a lot of potential if it retains some earnings and reinvests them."

Loans. Once a practice can show it has some retained earnings, Mr. Coddington said, its physicians have a better chance of going to a bank and getting a line of credit without needing to personally guarantee the loan.

When Health First Physicians first came together, for example, it went to a local bank and was able to get a half million dollar line of credit without any personal guarantees because of its reserves. "It's really tough for physicians to think about debt," Ms. Benton said, "but what I had to teach our physicians is that it's OK to borrow money, but make sure you don't borrow it from a hospital. You don't want the pressure to put heads on beds."

Hospitals. Although Ms. Benton suggests that doctors shy away from jumping in bed financially with a hospital, many practices have concluded just the opposite.

In a survey conducted last year, 70% of hospitals with 200 or more beds indicated that they owned medical practices, while 55% responded that they provided administrative services to physicians. (The survey is cited in Mr. Coddington's book.) Primary care practices are most commonly owned by hospitals; Mr. Coddington estimated that about 8% to 10% of physicians, most of them in primary care, now work for hospitals.

Nonetheless, many hospitals have reported financial problems with their groups. Mr. Coddington's book quoted a recent survey by Coopers and Lybrand that found that every employed physician cost the hospital $97,000 when direct revenues are compared with costs. Meanwhile, the accounting firm Ernst and Young has reported that losses in the range of $50,000 to $100,000 per hospital-owned physician per year are common.

Consultants predict that physicians will soon be affected by this trend. "Physicians who are employed by hospitals can expect the squeeze in the next two or three years as hospitals try to come to grips with their losses," Mr. Coddington said. This "squeeze" is likely to take the form of renegotiated employment contracts where a much greater percentage of the physicians' salaries will vary depending on productivity, and less of their salaries will be fixed.

For physicians thinking of forging financial ties to a hospital, all of this could be a blessing in disguise. Mr. Coddington explained that as hospitals learn from their mistakes, they are more willing to partner with physicians in ways that don't involve outright ownership. As a result, he said, hospitals should not be ruled out as capital partners.

PPMs and other equity partners. The national for-profit PPMs have probably gotten the most publicity over the last few years as they have acquired physician practices at an unprecedented rate. Mr. Coddington estimates that a little more than 5% of physicians—mostly specialists—are in about 250 practice management companies, compared to none 10 years ago. (About 30 of these PPMs are publicly owned.)

In general, PPMs start by acquiring a core group of practices and improve their financial performance through tight management. The management company then keeps adding more physicians to build the group so it meets the minimum requirements for an initial public offering. (According to "Capitalizing Medical Groups," practices should have at least $30 million in revenues and a growth rate of at least 20% per year before going public). The PPM then goes public, giving up around one-third of the equity—and hopefully earning a hefty rate of return.

With the rocky performance of some management companies on the stock market, however, this pace of acquisition has slowed. The growth of PPMs is anything but dead, however. In fact, it remains the largest single source of investment in physician practices.

As evidence of the health of the market for management companies, there is an unprecedented number of start-up PPMs looking for physician practices now. In addition, some experts see a huge new market for PPMs as hospitals try to sell physician groups that are unprofitable. "There is a subset of PPM companies that are focused completely now on the hospital market and getting those practices that were acquired by hospitals out of hospitals," said Michael Parshall, a consultant with The Health Care Group in Plymouth Meeting, Pa.

"While physicians tend to ridicule PPMs, I think they ought to be happy that they are there," Mr. Coddington said. "If you want to go to a bank and borrow money and the bank says, 'Well, how are you going to repay it?' you can say you have a business plan. But if that fails, you can say, "We can always go with a PPM or hospital and then you [the bank] will get your money back.' From a physician's point of view, as a result, I think what's happened in the last five years is really positive."

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